Minimum Contributions to a Top Heavy Plan

(Posted August 28, 2001)

Question 5:A plan is top heavy for its 2000 plan year. The key employees in this very small company must return part of their 401k deferrals for 2000 due to the ADP test, so that their average deferral percentage becomes less than 3% after their refunds. (It was 3% or more before the refunds.) The 401k deferrals are the only contributions into the plan; no other company contributions will be made other than a required top heavy contribution for the non-key employees. The company wishes to make the lowest possible top heavy contribution. Must the company contribute 3% for all non-highly compensated employees, or can it instead contribute the original amount the key employees deferred less the required refunds, which would result in a contribution of less than 3%?

Answer: Under the tax code's "top heavy" provisions (section 416 and Treasury Regulations section 1.416-1, Q&A M-20), salary reduction contributions are in the unenviable position of being counted for determining whether a plan is top heavy but not in determining the minimum contribution to be made to a top heavy plan for non-key employees. An exception to this rule exists for salary reduction contributions for key employees. Salary reductions for key employees up to 3% of compensation are counted for purposes of determining the minimum non-key employee contribution. Section 416(c) of the tax code requires that an employer generally contribute a minimum contribution to a top heavy defined contribution plan equal to 3% of each non-key employee's compensation. However, the minimum contribution does not have to exceed the percentage at which contributions are made under the plan for the key employee(s) for whom the percentage is highest for the year.

Therefore, if a plan that only provides for contributions through salary reduction is top heavy and any key employee makes salary reduction contributions in an amount greater than 3% of compensation, any non-key employee who contributes less than 3% would be entitled to an additional employer contribution up to the 3% minimum. For example, if the non-key employee contributes 1.5% of compensation and the highest key employee percentage is 4%, the non-key employee would be entitled to an additional 1.5% contribution (3.0% - 1.5% = 1.5%). In this plan, if the highest key employee salary reduction percentage is 2%, the non-key employee would be entitled to an additional 0.5% contribution (2.0% - 1.5% = 0.5%).

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